Tuesday, October 27, 2009

This is the longest-running theme on this blog: whatever problems the economy has, a shortage of money is not one of them. I've used it to counter the widespread belief at the end of last year that the economy faced the threat of deflation. When money is plentiful, deflation is nearly impossible. We know money is plentiful, because the price of money, as reflected in the exchange rate of the dollar and the price of gold, has fallen. The Fed has tried very hard to ensure that its supply of dollar money meets and/or exceeds the world's demand for it, and it looks like they have succeeded.

I've also used this theme to explain how the cause of last year's recession was a sudden decline in money velocity; people scrambled to increase their money balances by spending less and by effectively stuffing dollars under their mattress. This meant the recession was a giant shock to confidence which resulted in a huge increase in the demand for dollars. As confidence returned, I argued, money that was hoarded would get spent, and the economy thus had the ability to rebound rather quickly from its slump. All the signs I see suggest that the economy is pretty much following this script closely.

We now have the data for M2 money growth in the third quarter: -1.9% (annualized). This is not a fluke, since M2 growth has been effectively zero since the end of March. The initial estimate of third quarter GDP is due on Thursday, and the consensus calls for nominal growth of 4.6% (3.2% real growth plus 1.4% inflation, annualized). Thus we can estimate that M2 velocity in the third quarter rose at a 6.7% annualized rate. (see chart above) I think GDP probably did a little better in the third quarter, which would make the increase in velocity even more impressive. Bottom line: money that was hoarded is now being spent, and this is driving the recovery.

Money velocity (GDP divided by M2) is the inverse of money demand (M2 divided by GDP). So we can say that the big news in the quarter that just ended was a significant decline in money demand, after a major rise in money demand that dominated the economic news last year and earlier this year. Lots of evidence comes together to support this: as money demand has fallen, the dollar's value on the foreign exchanges has also fallen; growth in dollar currency has also fallen; and commodity and equity prices have risen as the world attempts to reduce money balances and increase exposure to more risky assets. It's all tied together with confidence: as evidence accumulates that the economy is not falling off a cliff and banks are not going to disappear massively, money comes out of hiding. Dollars that were stored are being spent, converted to other currencies, and/or exchanged for more risky assets.

I still see lots of people worrying that the U.S. could end up like Japan—unable to pump up the economy no matter how hard the central bank tries to ease monetary policy. I don't see many parallels to worry about, however. For one, the yen's value has been rising for decades, which is prima facie evidence that the Bank of Japan hasn't really tried all that hard to increase the supply of yen relative to the world's demand for yen. In contrast, the dollar is very near its all-time low relative to other major currencies, so we know the Fed has been far more accommodative, historically, than the BoJ. Second, M2 velocity in Japan has been declining almost nonstop for the past 30 years, whereas M2 velocity in the U.S. has been relatively stable on balance (though quite volatile at times). This suggests strongly that there are some big structural differences between the two economies. The BoJ has traditionally been much more cautious than the Fed, and the Japanese have been much more willing to hold on to their currency (e.g., by saving more and borrowing less) than U.S. consumers.

All the evidence points to rising money velocity in the U.S. This, coupled with the Fed's continued willingness to supply tons of money to the system, strongly suggests that 1) the U.S. will avoid depression, 2) the U.S. economy is very likely to continue growing, and 3) rising inflation, not deflation, is the most relevant concern for investors. For the time being, this should translate into continued weakness for the dollar, and continued strength for commodities, gold, and equity markets.

10 comments:

... so the government does not need inflation to avert a potential recession (like Japan needed but never effected), but they still need (prefer?) inflation and low rates to pay the US debt. How will they square the equation? Where to look for signs? Besides, if they wanted to slow significant inflation when (if) it comes, will they be able to do so effectively?

I am as skeptical as anyone, but I am not going to jump to the conclusion that what the Fed is doing is a big masterminded plot to inflate the government out of its massive debt load. That may well happen, but I don't believe this is the idea that is driving Bernanke & Co. I believe they are trying to do their best, but I also believe that they are fallible. I won't trust them with my blind faith. I will watch very carefully how things play out.

Scott you are hitting it out of the park. Thank you. If the recovery does not come fast enough for commercial loans to be serviced and we have bank failures, what would you look at as an early indicator and do you see more bank failures(because we bid up this real estate too much in the bubble) even with a recovery in place as a potential threat?

Public: a friend of mine, Brian Wesbury, has increased his GDP call for Q3 to 4% or more. Whatever the number is, it is likely to be revised in coming months. But as long as it is at least 2.5% that will be a sign that the recovery is indeed in place and velocity is rising. And don't forget these are annualized numbers, so the difference between 2.5% and 3.5% is only 0.25%. That is a rounding error for the GDP stats.

ronrasch: even if we have a 3-4% (on average) recovery, there will undoubtedly be some more bank failures and commercial loan defaults. It would take a really strong recovery to wipe away all the lingering problems from the real estate collapse. Unfortunatley that scenario has most likely been eliminated by the Democrat's very poorly designed stimulus plans.